Paul Krugman: Just Say AAA

Paul Krugman looks at "the fuss over C.D.O.’s," and the responsibility of bond-rating agencies and regulators for some of the consequences of the collapsing housing bubble:

Just Say AAA, by Paul Krugman, Commentary, NY Times: What do you get when you cross a Mafia don with a bond salesman? A dealer in collateralized debt obligations (C.D.O.’s) — someone who makes you an offer you don’t understand.

Seriously, it’s starting to look as if C.D.O.’s were to this decade’s housing bubble what Enron-style accounting was to the stock bubble of the 1990s. Both made investors think they were getting a much better deal than they really were...

To understand the fuss over C.D.O.’s, you first have to realize that in the later stages of the great 2000-2005 housing boom, ... there was an explosion of subprime lending...

For a while, the risks of subprime loans were masked by the housing bubble itself: as long as prices kept going up, troubled borrowers could raise more cash by borrowing against their rising home equity. But once the bubble burst ... many of these loans were bound to go bad.

Yet the banks making the loans weren’t stupid... Subprime mortgages ... were securitized..., banks issued bonds backed by home loans, in effect handing off the risk to the bond buyers.

In principle, securitization should reduce risk... But ... it’s now clear that many investors ... didn’t realize what they were getting into.

And it’s also becoming clear that ... many investors were fooled by fancy financial engineering ... into believing they had protected themselves against risk, when they had actually done no such thing...

C.D.O.’s are ... supposed to transfer most of the risk of bad loans to a small group of sophisticated investors, who are compensated ... with a high rate of return, while leaving other investors with a “synthetic” asset that is, well, safe as houses.

S.& P., Moody’s and Fitch, the bond-rating agencies, have gone along..., telling investors that the synthetic assets created by C.D.O.’s are equivalent to high-quality corporate bonds. And investors have ... “snapped up” these securities “because they typically yield more than bonds with the same credit ratings.”

But the securities were never as safe as advertised, because the risk transfer wasn’t anywhere near big enough to protect investors from the consequences of a burst housing bubble. It’s not quite the metaphor I would have come up with, but here’s what ... Bill Gross had to say about C.D.O.’s...:

“AAA? You were wooed Mr. Moody’s and Mr. Poor’s by the makeup, those six-inch hooker heels, and a ‘tramp stamp.’ Many of these good-looking girls are not high-class assets worth 100 cents on the dollar.”

Now we’re looking at huge losses to investors who thought they were playing it safe. Estimates ... range from $125 billion to $250 billion, with some analysts warning that a wave of distress selling will deepen the housing slump even further.

Now, you might have thought that S.& P. and Moody’s, which gave Thailand an investment-grade rating until five months after the start of the Asian financial crisis, and gave Enron an investment-grade rating until days before it went bankrupt, would by now have learned to be a bit suspicious. And you would think that the regulators, in particular the Federal Reserve, would have learned from the stock bubble and the wave of corporate malfeasance that went with it to keep a watchful eye on overheated markets.

But apparently not. And the housing bubble, like the stock bubble before it, is claiming a growing number of innocent victims.

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